Three Winning Portfolios

As miserably as Standard and Poor's 500-stock index has performed recently, it still has beaten two-thirds of big-company U.S.-stock funds over the past five years. And that, in a nutshell, is why simple portfolios of index mutual funds still make sound financial sense for many investors: They're a dependable way to get better-than-average returns.

Index funds seek to mirror a variety of barometers of the stock and bond markets. Rather than attempt to outpace the markets, these funds aim to match the performance of their indexes -- saving you the time and effort of trying to pick actively managed funds that you hope can consistently outperform the markets. Funds that are actively managed often beat their benchmarks over short periods of time, but few of them outperform over the long haul.

Why do index funds do so well? Mainly, it's because of their low costs. Index funds don't require highly paid managers and analysts to research companies, so they're generally cheap to operate. Vanguard 500 Index (symbol VFINX) carries an annual expense ratio of 0.15%, meaning that for every $1,000 you have in the fund, Vanguard will extract just $1.50 per year for operating costs. That compares with an average expense ratio of 1.4% for all diversified U.S.-stock funds.

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Consider the impact of this on a $100,000 portfolio that earns 10% per year before fees. Compared with someone who owns a fund that charges the average expense ratio, an investor in Vanguard 500 Index would earn an additional $28,000 over ten years (not including the impact of taxes).

Because different parts of the stock market often move independently of each other, you can build a portfolio with steadier results by holding funds that focus on different areas. For example, in 2001 the S&P 500 lost 12%. But the Russell 2000, which tracks 2000 small U.S. companies, rose 2.5%.

In reviewing the portfolios of index funds Kiplinger's has recommended over the past ten years, we didn't find any that disappointed. So based on our tried-and-true methodology, we offer three portfolios for different goals:

Long term: 10-plus years away

Here's an all-stock portfolio that covers not just big and small U.S. companies, but foreign stocks and real estate as well. We've chosen Vanguard index funds, but you can just as easily use other low-cost index funds and exchange-traded funds that cover the same territory. The iShares brand of ETFs (iShares S&P 500 for big-company stocks and iShares Russell 2000 for small-company stocks, for example) would work just as well.

This portfolio returned an annualized 6.4% for the past three years through July 31 and 12.4% for the past five. Compare that with 2.9% and 7% for the S&P 500.

35% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks

25% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks

25% Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks

10% Vanguard REIT (VGSIX) -- Real Estate Investment Trust

5% Vanguard Emerging Markets Stock (VEIEX) -- Emerging-country stocks

Medium term: 5 to 10 years away

You're getting closer to your goal-be it funding retirement, paying for college or fulfilling some other large call on cash-so we've reduced the risk of this portfolio by allocating 30% to a bond fund, which should help your portfolio achieve smoother performance. Less volatile than the long-term portfolio, this collection returned 4.9% and 9.2% annualized over the past three and five years, respectively.

30% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks

30% Vanguard Total Bond Market (VBMFX) -- Broad bond index

15% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks

15% Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks

10% Vanguard REIT VGSIX) -- Real Estate Investment Trust

Short term: Fewer than 5 years away

You need to think more in terms of preservation of capital and current income, so we've bumped up the weighting in bond funds to 40%. The least volatile of the three portfolios, it returned an annualized 5% and 8.7%, respectively, over the past three and five years.

30% Vanguard Total Bond Market (VBMFX) -- Broad bond index

25% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks

10% Vanguard Short-Term Bond (VBISX) -- Mainly U.S. Treasuries

10% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks

15%Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks

10% Vanguard REIT (VGSIX) -- Real Estate Investment Trust